The benchmark US Treasury 10-year bond set a new low yield record on 9 March 2020, at just 0.54%. Although we have been living in a period of low interest rates for some time now, these new lows compare to just 18 months ago when US Treasury 10-year bonds were yielding over 3%. The interest rates on federal debt obligations not only impact the credit markets, but also impact federal minimum interest rates for tax purposes. Under Section 1274 of the Internal Revenue Code, the IRS publishes the Applicable Federal Rate (AFR) for three points along the yield curve, based upon the federal Treasury rates. The AFR applies to a number of common planning scenarios. Additionally, depressed asset valuations result in further planning considerations.
Inter-family loans. Private loans between related parties are a common family planning device. Generally, interest paid by the borrower to the lender is interest income to the lender. No interest or below-market loans result in deemed interest income to the lender and a corresponding deemed gift of foregone interest to the borrower. Lower interest rates significantly reduce the interest income inclusion and gift tax costs to the lender.
Inter-family loans are used for a number of purposes, but one simple idea is to grant a loan to a family member who then uses the loan to purchase an appreciating asset from the wealth owner. Doing so removes the appreciating asset from the wealth owner's future estate. Additionally, given that today's financial environment has not only reduced interest rates but also lowered asset valuations, this sort of planning is particularly attractive at the moment.
For families with existing inter-family loans, these loans may be refreshed at current lower rates.
Outright gifts. Income-producing assets normally increase in value when interest rates decline, but given the current financial environment, asset valuations are broadly lower. Lower valuations reduce the gift tax exposure arising from making gifts. For US citizens and residents, the 2020 unified gift and estate tax exemption is $11,580,000 per individual. This exemption amount is scheduled to sunset under current law in the 2026 tax year, and revert to an amount inflation-adjusted from a $5,000,000 base. The IRS has issued previous guidance allowing for gifts made before the sunset takes effect to be grandfathered in for decedents dying after the sunset takes effect (in 2026 and later years). For those contemplating making a future gift, now may be a propitious time to remove assets from one's future taxable estate as lowered valuations allow for more assets to be gifted under the unified exemption than is normally the case.
GRATs. Additionally, many estate planning tools, such as Grantor Retained Annuity Trusts (GRATs), are more favorable when asset valuations and interest rates are low. In a GRAT, the grantor transfers property to an irrevocable trust in return for the right to receive fixed payments on at least an annual basis based upon the initial fair market value of the property. Essentially, a GRAT pushes the future appreciation of an estate asset out of the taxable estate and on to the trust in exchange for a cash down payment and a promissory note. The grantor receives interest payable at today's low interest rates.
Family businesses. Shareholder loans are a way to take cash out of corporate solution without incurring dividend tax treatment. Interest must be charged at least at the AFR and such interest is income to the corporation. With lower interest rates, the relative attractiveness of shareholder loans improves. Conversely, business owners may now prefer to capitalize family business with debt over equity given low current interest rates and the flexibility that debt capitalization provides. Care must be taken with the above planning, however, as special rules apply.
Additionally, closely-held businesses may find themselves in loss rather than profit positions given the current circumstances. For closely-held businesses which are not completely flow-through (such as by having "C corps" in the structure), losses may be trapped at an underlying level. Also, once an entity taxable as a corporation becomes profitable once again, dividends paid out of current earnings and profits are taxable under the "nimble dividend" rule despite the existence of a deficit in accumulated earnings and profits. Restructuring or an elective change in classification of an underlying entity could be used to unlock trapped losses or achieve other planning objectives.